CMBS Issuance On Track for Record Volume in 2004

These are heady days for commercial real estate marked by low Treasury rates, skinny spreads and loose underwriting standards that even a borrower could love. According to the Barron's/John B. Levy & Co. National Mortgage Survey, lenders are booking new business at unprecedented levels, and issuance of commercial mortgage-backed securities (CMBS) is headed for record levels on both the global and domestic fronts this year. CMBS issuance in the U.S. totaled $77.8 billion in 2003, while global issuance totaled $20.8 billion, according to Commercial Mortgage Alert.

There were four fixed-rate CMBS offerings in the last week of October, each seeking to raise more than $1 billion. The most interesting was a $1.1 billion issue from Credit Suisse First Boston, which presented a “super senior” structure for the first time to fixed-rate CMBS buyers. Previously, all triple-A-rated securities had the same credit support, or subordination, which has been declining precipitously.

For example, as recently as 2002, RBS Greenwich Capital notes, triple-A tranches enjoyed an average subordination level of almost 21% (the higher the level, the bigger the cushion for the security holder). That's now declined to a riskier 14.5%. As Dan Ivascyn, executive vice president of Pimco, puts it, “The rating agencies have gotten a little ahead of themselves in terms of subordination levels,” meaning the agencies have grown too generous in their ratings in the face of declining subordination levels.

But not to worry. With the new super-senior structure, triple-A buyers can enjoy 20% subordination levels at the super-senior level, or choose a junior triple-A-rated tranche with a more normal credit support level of 13%. The market responded favorably to the super-senior bonds, which were thought to price at interest-rate swaps plus 31 basis points, or 0.31 of a percentage point, tightening at the closing to interest-rate swaps plus 29 basis points. Meanwhile, the junior triple-A tranche was priced at interest-rate swaps plus 35 basis points.

Ripple Effect of Insurer Scandal

New York Attorney General Eliot Spitzer now has the insurance industry in his crosshairs. Since insurers are big CMBS buyers, it's reasonable to suspect the latest investigation could suppress companies' appetite for new offerings.

To be sure, most of the investigation has been on the property and casualty side, while life insurers have been the more likely buyers of commercial mortgages. But Spitzer's investigation could lead to jitters in the market.

The probe could hinder the extension of the federal law that allows owners of large commercial buildings to buy government-backed property and casualty insurance for acts of terrorism. Although most analysts expect the law, which expires at the end of next year, to be extended, it could stumble if the prevailing political wisdom is that insurance companies, as revealed by the Spitzer investigation, were dealing with their clients in an underhanded and perhaps unethical fashion.

Impact of Prepayment Penalties

Unlike home loans, nearly all fixed-rate commercial mortgage loans carry prepayment penalties. For borrowers who obtain their loans from conduits — lenders that make loans to resell them as securities — the most likely type of prepayment penalty requires defeasance. Under that scenario, the borrower buys a series of qualifying U.S. government securities that provide the same cash flow as the loan being prepaid.

Most borrowers believe they're required to purchase only Treasury securities. In fact, the definition of a U.S. government security under the federal law that regulates CMBS is broader. According to Rob Finley, managing principal of consulting firm Commercial Defeasance, the law allows borrowers to buy Fannie Mae, Freddie Mac and other government-backed securities.

According to Finley, since Fannie Mae and Freddie Mac securities trade at higher yields than Treasuries, they could save borrowers 10% to 20% in prepayment penalties. Since a prepayment penalty can be a multimillion-dollar affair, the savings are no small number.